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Stepping Up Your Savings

You may think you know everything you need to about bank CDs. As interest rates have fallen, however, banks have made some changes to traditional CDs to be more attractive to investors.

Before you decide to put your money into a CD with fancy features, be sure you understand how they work. Even if one particular feature sounds good, you might not get your money's worth -- or you might get an unexpected surprise down the road.

Betting on a rise
It seems like clockwork: Rates start falling and banks offer CDs that let investors bet rates will go back up. These CDs -- called bump-up, step-up, or rising-rate CDs -- pay an initial interest rate just like a regular CD. But if prevailing rates go up, then the CD owner can elect to receive the higher rate for the rest of the CD term until it matures. US Bancorp (NYSE: USB  ) and PFF Bancorp (NYSE: PFB  ) are among the banks that offer step-up CDs, and you'll often find promotions for them at local banks and credit unions.

There are a few things you have to watch out for with these CDs. First, the initial rate on a step-up CD may be lower than rates for traditional CDs, so unless rates rise, you might end up making less with the step-up CD. In addition, even if rates do go up, they have to go up early enough in the term to make a difference. It does you little good to take a higher rate for just the last month or two of your CD term.

Also, the mechanics of these CDs can be confusing. Usually, the bank won't automatically give you a better rate -- you have to keep track of rates and take action to get the higher rate yourself. Most of the time, you can only elect to increase your rate once, so market timing is involved. And finally, if you decide to let your step-up CDs roll over to a new term, don't assume that your new ones will have the same step-up provisions -- they often won't.

Taking the other side
On the other hand, callable CDs give investors the opposite incentive. Callable CDs have an initial term that's fairly long -- typically five years or more. But the bank retains the option to shorten the term of the CD by calling it. In exchange for this option, the bank usually pays a higher interest rate. Plenty of banks offer callable CDs, including the Royal Bank of Scotland's (NYSE: RBS  ) Citizens Bank, the banking division of Countrywide Financial (NYSE: CFC  ) , and Lehman Brothers (NYSE: LEH  ) .

Depending on the fluctuations of prevailing interest rates, one of two things usually happens with callable CDs. If rates keep falling or stay stable, then the bank will often call the CDs early, giving you your money back to reinvest at lower rates. But if rates rise, then the bank won't call the CDs, and you'll have to hold onto them for their full term.

Planning with callable CDs presents a big challenge. Fitting them into bond ladders is difficult because you can't be sure whether you'll own that CD for a full 20-year term or whether it'll get called after three or six months.

Whatever decision the bank makes, it appears that you get the short end of the stick. If rates fall and your CD gets called, you'll get the nasty surprise that your income will drop substantially when you reinvest the proceeds in a new CD. Yet if rates rise and your CD doesn't get called, you're stuck with rates that are lower than you could get with a new CD.

Know what you're getting
That's not to say that step-up and callable CDs are always bad deals for investors. Sometimes, the base rate on a step-up CD is so attractive it doesn't matter if you get a higher rate. And the extra interest on a callable CD may compensate you for having to find another investment sooner than you expected.

The main trap with these CDs catches those who don't understand how they work. Their names make it easy to assume certain things that may turn out not to be true. Get the facts before you invest, and everything should turn out fine.

You can learn more about saving by reading about:

Our Savings Center can give you plenty of details on how to make the most of your savings.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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